A history lesson on fiscal deleveraging

From Nathan Sheets at Citi, courtesy of Zero Hedge:

In the years after World War II, the United States achieved a dramatic reduction in the level of the federal government’s debt. The costs of financing the military had pushed the debt up sharply, from around 40 percent of GDP before the War to a peak of nearly 110 percent of GDP as the War ended. But a combination of strong economic growth and remarkably disciplined fiscal policies, as well as elements of socalled financial repression, brought the debt below 50 percent of GDP by the late 1950s. This remarkable episode provides some important perspectives for us today as the debt is again on a high and rising trajectory.

The sharp decline in the public debt after World War II was driven by several factors. The first was a highly disciplined fiscal policy. During this period, a strong social and political consensus prevailed in favor of budgetary restraint and debt reduction. The government’s budget registered sizable surpluses in the late 1940s as military efforts were wound down, and then cycled near balance through the following decade. Notably, government outlays moved up some during the years of the Korean War, but this increase was matched by revenue measures, which allowed the military spending to be financed without additional debt issuance.

The strong growth of U.S. real GDP in the years after World War II was a second factor that contributed to reducing the government’s debt burden. The U.S. economy initially contracted in 1946 and 1947 in the face of a sharp scaling back of military spending, prompting concerns about the possibility of sustained recession and rising unemployment. But the economy was rapidly transformed into peace-time production, with strong consumer demand (which had been pent-up through the Depression and the War) quickly taking hold. Demographics were also favorable, as the returning GIs married and the baby boom ensued. From the late-1940s through the late-1950s, annual real GDP growth proceeded at a strong 3¾ percent pace.

U.S. fiscal deleveraging during this period was also supported by some less benign factors. During the War years, the Federal Reserve pegged long-term interest rates at very low levels in an effort to minimize the government’s debt-service burdens. To ensure that the accommodative policy stance did not translate into rising inflation, the government adopted wage and price controls. After the war, as these controls were dismantled, the price level surged upward. All told, consumer price inflation averaged about 6½ percent annually from 1946-51. This, in turn, inflated away a sizable chunk of the government’s debt burden.

Under usual conditions, such a burst of inflation would have quickly driven up borrowing rates. But bowing to pressures from the Treasury, the Federal Reserve continued to cap long-term government bond yields at 2½ percent until the spring of 1951. The upshot was that real interest rates (i.e. adjusted for inflation) were sharply negative during the years following World War II. These negative real interest rates supported the government’s deleveraging objectives, but did so at the expense of those holding the debt.

Carmen Reinhart and various co-authors have termed government policies used to achieve redistribution through such channels “financial repression.” Although financial repression may be achieved using a variety of mechanisms — including by capping interest rates, restricting competition in the financial sector, or introducing capital controls — the common underlying objective is to induce investors to hold government debt at yields lower than would other otherwise be required. As a practical matter, negative real interest rates such as those observed in the United States during the 1940s are a defining feature of financial repression.

The experience with fiscal deleveraging after World War II offers some striking lessons, as well as some important caveats, for the United States in the present episode. Since the global financial crisis erupted in 2007, federal debt held by the public has risen from below 40 percent of GDP to over 70 percent. And the aging of the baby boomers is likely to drive further increases in the years to come if action is not taken to rein in the path of spending relative to revenues. A natural question is whether the United States will be able to defuse these fiscal pressures and, as in the years after World War II, engineer a successful deleveraging. A related question is the extent to which the post-War experience might serve as a useful template for a solution going forward.

As a general statement, the prognosis on this score is not encouraging. Even if the headwinds that are now afflicting U.S. aggregate demand quickly abate, economic growth is unlikely to be as strong as that recorded in the late-1940s and 1950s. At the very least, demographics are less supportive. Similarly, while we cannot dismiss the risk that the Federal Reserve may stumble as it eventually exits from its unconventional policies, a burst of inflation approximating that seen in the late 1940s seems unlikely. The Fed’s commitment to maintaining price stability is underscored by the recently announced 2 percent inflation target. Although the Treasury dominated the Federal Reserve in the late 1940s, understandings of central bank independence have evolved significantly over the past sixty years.

The possibility of financial repression is something of wildcard. Given the current size and sophistication of the financial sector, financial repression is unlikely to be an explicit object of policy; specifically, real interest rates will probably not be maintained at negative levels for the purpose of facilitating the government’s debt financing. But interest rates or increase the relative attractiveness of assets issued by the government.

The following are two examples. First, the Fed’s ongoing Operation Twist has been designed to boost economic activity and avoid deflationary pressures, consistent with the Fed’s dual mandate. However, Twist achieves these objectives by driving down real long-term interest rates and increasing the scarcity (and, hence, the attractiveness) of long-term Treasuries. Second, the Basel rules give government securities a zero risk weight; while this feature is increasingly vulnerable to criticism its primary goal is to provide incentives for institutions to hold safe assets, not to finance the government debt. Whether such policies should be classified as financial repression is very much in the eye of the beholder.

With the other mechanisms that were used to reduce the debt burden after World War II likely to be less powerful in today’s world, fiscal discipline must accordingly be a central feature of the policy mix in the years ahead. Exactly how this should be achieved is more a political than an economic question, with a whole range of possible solutions. The key is to find a path for expenditures and revenues that avoids the so-called “fiscal cliff” in the near term but that firmly reduces the trajectory of the debt over the medium to long run. Without such a solution, we leave ourselves vulnerable to the vagaries of sentiment in the bond market, thus opening the door to an unwelcome set of severe financial risks.

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